If you found this article, you know one thing for sure: Due diligence is a necessary process fraught with challenges, requires careful execution, and can be a make or break activity. So, you’re in the right place.
Throughout this piece, we will focus on the legal due diligence process, and how you can avoid getting caught with your pants down. Say ‘no’ to getting bamboozled and level up your strategy, so you can make certain every relationship you invest in is a secure one.
Let’s look at the actual definition of due diligence from our friends as Oxford Dictionary:
due dil·i·gence
(noun)
— reasonable steps taken by a person in order to satisfy a legal requirement, especially in buying or selling something.
— a comprehensive appraisal of a business undertaken by a potential buyer, especially to establish its assets and liabilities and evaluate its commercial potential.
Basically, “...investment due diligence is a necessary process for both buyers and sellers to undertake to ensure the swift execution of their envisaged transaction,” and is an integral step in any business relationship dealings.
In terms of these steps, due diligence typically commences after your business associate has offered a letter of intent, or term sheet.
Next, you work with your team to conduct an assessment over the course of one or two months, and this assessment is where you and your team review all the investment details, financial records, assets, and data to check for any inconsistencies.
“Due diligence allows the potential buyer to confirm pertinent legal information about the seller, such as contracts, finances, and customers. By gathering this legal information, the buyer is better equipped to make an informed decision and close the deal with a sense of certainty.”
And lastly: “Due diligence generally commences when the letter of intent (LOI) is signed. Learn more about due diligence in mergers and acquisitions, what steps you can expect to happen during the M&A process, and why due diligence is very important,” writes Brandon Brown of Business Benefits Group.
For the purposes of this article, we will primarily focus on “investment due diligence.”
This bucket under the due diligence umbrella covers a wide range of scenarios. In this article, we will focus on checklists for startup and VC funding, Mergers & Acquisitions, debt financing, and long-term supply contracts.
How each of these scenarios plays out in regards to due diligence will be unraveled as each scope and approach will vary.
Whether you’re a …
…you’ll see how to avoid any missteps along the way to perform operational due diligence - using this handy Due Diligence 101 Guide.
Savvy investors and venture capitalists are no strangers to bad actors. Since Silicon Valley exploded in the late ‘90s, we now live in a world where things like the Elizabeth Holmes’ Theranos scandal are, sadly, common occurrences. The long-short of it: Shrewd investors know that there are nefarious characters out there looking to swindle.
So, how do smart investors prevent getting hoodwinked? There are several tried-and-true steps, but along the way, oftentimes, we get comfortable with skipping some steps. Especially if we get a personal referral or recommendation, but take it from Ferret, this potential risk is never a good idea.
What you should see is a broad swath of expertise. This team should have exceptional skills that can help elevate your business.
One of my favorite bits of advice comes from GroundFloor Partners, they write:
“Ask to see the most important legal documents for the company (articles of incorporation, operating agreement, etc.) Check the Secretary of State’s office, and any other relevant certification or compliance agencies to make sure the company follows state rules and regulations. Are there any outstanding lawsuits, liens, or judgments against the company or its officers? Have there been any in the past? If so, are these legitimate, and do they reveal major problems with the organization?”
This is, of course, one of the cornerstones of due diligence. But most advice-givers offer the same preponderance of information: check with the Secretary of State office. That’s a tall order, and will likely yield very little information. And it’s a slow process…
Ask for an anti-reference.
An anti-reference is exactly what it sounds like. It’s a reference where the person you are vetting was involved in a deal that went south. What you’re looking for here is how this person acts when they’re in a legitimate bind.
Examples include:
- A portfolio company, where they followed up in later round
- A portfolio company that raised further capital, but where they decided not to follow up
- A portfolio company that failed
“You will hear how they behave at their worst, and it will most likely not be sugar coated. A serious investor should both be conscious about this, and willing to share. If they cannot think of such a person or occasion, that’s a telltale too…,” explains Sanna Westman, an investment-focused blogger.
“Ask to be introduced to founders they have worked with before. Ideally, you would talk to people who were at a similar stage (seed, A-round etc) as you but where the outcome differed e.g.,” Westman goes on to note.
Explore these eight aspects of proper due diligence all investors need to focus on to ascertain whether they’re making a sound decision. Here’s a quick roundup:
Get a look under the hood of your investments by checking the company’s financial statements and projections. VCs and investors should have consistent methods for measuring their potential investments finances, though areas of interest may vary between different industries.
A financial check will come early during the vetting process. In fact, it’s likely the very first step when considering an investment. Entrepreneurs don’t have time to involve themselves in financially unstable or fruitless endeavors.
What numbers are you interested in? Typically a full-financial check will involve examining data related to:
Your potential investment industry should have all these metrics readily available, but you may want to consider proceeding with your own audit.
You can request the raw numbers from the business in the form of financial statements like:
Hold off on any investment until you’ve processed all relevant financial statements. It may take several weeks to secure the necessary materials and approvals to move forward.
For regulated industries, such as privacy-focused firms, financial institutions, and manufacturing firms, it’s imperative to ensure all aspects of the business abide by state and federal regulations.
Compliance can be a time-consuming and costly process, but the cost of non-compliance is substantial. Any business operating without full compliance is a major potential risk for potential investors.
A regulatory audit aims at ensuring all projects, personnel, and business affairs are above board and aligned with all known requirements.
To conduct a proper regulatory audit, take note of the following:
Ensure your potential investment is in full compliance with the tax code. An audit from the IRS can be a major setback for businesses and their investors, so due diligence demands a full tax assessment of any business you’re looking to invest in.
Businesses may be responsible for paying any of the following:
Many of these taxes vary from state to state, and where a company operates and incorporates can have an impact on their total taxes. Investors should spend time with a business’s accountants and tax professionals for a full understanding of their tax compliance. Additionally, you may request IRS documentation and proof of payment.
When conducting due diligence, VCs and investors need a clear understanding of their liabilities when investing in a company. Your rights and protections as a potential investor should be clearly outlined during financial negotiations.
During the due diligence process, there are several key liability questions to consider, including:
A licensed legal professional can provide clarity during a liability compliance audit. A trusted third party may be the best route for a sound investment and total assurance.
Copyrights, trademarks, and patents all fall under the umbrella of intellectual property (IP). For VCs and investors, it’s crucial that a business stringently follow all laws related to IP compliance. Otherwise, the business may fall prey to heavy fines and legal ramifications.
IP can impact the large and small aspects of any business, and may cover materials like:
As well as the actual products that the business produces.
For the purposes of due diligence, investors should take careful note of the following IP-related procedures and institutions:
Is a company practicing safe and professional behavior regarding its IT department? Today, digital infrastructure and cyber protection are more important than ever before.
Consult with the business’s IT team and conduct an internal audit based on the businesses response to current digital threats such as:
Malware and ransomware – Critical data can be taken and held by bad actors in exchange for a financial payout. Additionally, servers and databases may be at risk of malicious software aimed at disrupting digital systems.
Data leakage – Without proper protection, a company could risk exposing their clients’ and investors’ sensitive information. High-level security measures should be implemented to prevent data leaks.
Insider attacks – Threats to a company’s interests may come from within. Businesses should conduct secure digital operating procedures, offloading, and continual reassessment to protect against insider attacks.
Examine the business's daily operating costs and expenditures from a human resources perspective. Take the business’s everyday operations into account to develop a larger perspective of their investment potential.
A comprehensive operations analysis may include:
All businesses are chiefly concerned with their space in the market. Market share due diligence involves inspecting their proposed market value in relation to competitors, as well as their strategies for growth.
Key data for understanding a business’s market share may include:
The company should provide actionable data to capture its market while expanding across others.
There’s actually not a vast difference between VC due diligence and M&A due diligence but one factor sticks out: Confidential Information Memorandum (CIM)
According to The Corporate Finance Institute, “A Confidential Information Memorandum (CIM) is a document used in mergers and acquisitions to convey important information about a business that’s for sale including its operations, financial statements, management team, and other data to a prospective buyer.”
Also known as an Offering Memorandum, this step involves hiring an investment banker, or an M&A specialist, or advisory firm to create an accurate profile of the company the buyer is looking to acquire.
“The banker prepares the CIM and uses it as a marketing document, which is intended to make the company look attractive as the objective is ‘not just to sell, but to sell for maximum value.’ The reason an investment banker tries to sell a company at the maximum value is because they represent the best interest of their client (the seller), and their commission is based on the sale price,” The Corporate Finance Institute notes.
During the sales process, the banker builds content for the Confidential Information Memorandum; an example table of contents for an offering memorandum can be seen here:
The process of due diligence is a complex and demanding procedure that requires expertise and experience. To stay protected and profitable regarding all your investments, connect with Ferret—the industry leader in due diligence tech and world-class relationship intelligence.
ferreter [noun](plural ferreters):
A person who hunts with ferrets.
One who uncovers or brings to light; one who ferrets out.
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